Dovish Fed Surprises Markets, but Will Stock Rally Last?

The Federal Reserve managed to surprise a well-primed Wall Street with aggressive commitments to ease until the economy shows signs of healing.

As expected, the Fed announced a new version of quantitative easingand extended its low-rate policy to mid-2015, but it also took the unusual steps of promising to continue mortgage and other asset purchases if it does not see significant improvement in the labor market.

In other words, the Fed was able to provide a new easing program, as expected by markets, and also provide the carrot for promises of future easing.

“I think this is monumental and historic,” said Lord Abbett fixed income strategist Zane Brown. “I imagine the Fed is likely to come under considerable criticism for assuming that monetary policy can be effective in creating employment. That is the dual mandate, but I’m not sure people can prove a correlation between that and purchasing mortgage securities.”

For the markets, at least, the main question is whether the Fed's action will keep the stock rally going.

“I think we rally for the next few days off of this, but I don’t know that it really does anything," said Steve Massocca of Wedbush Securities. "We’ve been to this movie before."

“Low interest rates also support the value of many other assets that Americans own, such as homes and businesses large and small,” he said at the press briefing following the Fed's decision.

“It is difficult to save for retirement or other goals without the income from a job. Americans will ultimately benefit most from the healthy and growing economy that low interest rates can promote,” Bernanke said.

He said the mortgage purchase program should help keep the pressure on interest rates, particularly mortgage rates which should spur purchases and refinancing in a housing market that is showing signs of improvement.

While traders had been expecting a muted market response, the Fed statement and Bernanke’s later comments helped drive a strong stock market rally, which pushed the Dow 206 points higher to 13,540. The S&P jumped 1.6 percent to 1459. Gold rose nearly 2 percent, oil jumped 1 percent and Treasury yields rose initially on the long end but then moved lower.

“Not only was the statement sort of easier than expected, the language was easier than expected. They basically said we’re in danger ... they basically said if we don’t do this we have a major problem,” said BTIG global market strategist Daniel Greenhaus.

The Fed, in its statement, noted that business fixed investment appears to have slowed, while household spending continued to advance. It also said economic activity continued to expand at a moderate pace in recent months, compared to its August statement when it said economic activity decelerated somewhat over the first half of this year. But the Fed noted that employment growth is slow and unemployment remains elevated.

“The vast majority of economists on Wall Street think this is going to have only a modest impact on economic growth and the employment rate, perhaps 0.2 to 0.3 (percent) on either, and from the Federal Reserve standpoint, they were dealt a bad hand, and they’re doing their best to deal with it,” said Greenhaus.

“From a market standpoint, you’ll see a reaction quite soon, and the economy in theory would respond to this in a year," he said. "Monetary policy operates with a lag."

Some economists say the Fed action was prompted in part by its fear the economy could hit the “fiscal cliff” this January, when Bush tax cuts expire and automatic spending cuts take place without Congressional intervention. (Read more: Leaders Remain Far Apart on Fiscal Cliff)

“This should provide a head of steam for sure, but I don’t think this would matter if we went over the cliff full bore," Greenhaus said. "I don’t think this would prevent a recession.”

The Fed announced it would purchase $40 billion a month of mortgage securities in an open ended program that would bring its monthly asset purchases to a total of $85 billion, when including its continuing replacement of the securities in its portfolio as they mature.

It also said it would continue Operation Twist until it expires at year end. That program involves the purchase of longer dated Treasury securities and the sale of an equal amount, in an effort to pressure rates at the long end.

Brown said the Fed may have a hard time finding enough mortgages to buy if it keeps its program going. He said about $530 billion in conventional mortgages were created in the first half of the year, and he expects that’s about the amount the Fed would buy in a year.

“Certainly it’s going to have an impact, and it will (help push) mortgage rates down,” Brown said.

“When you consider they are going to have this highly accommodative stance, even after the economic recovery strengthens, almost by definition it will generate inflation,” Brown said.

The Fed action was immediately criticized by politicians, including Republican presidential candidate Mitt Romney who said it shows President Barack Obama’s policies are failed. Bernanke, in response to a reporters’ question said the Fed does not focus on politics and makes its decision based on the economy. Romney and running mate Rep. Paul Ryan, R-Wis. opposed more Fed easing.

“What they’re (the Fed) saying is we’re going to keep things easy even when we’re growing,” said CRT Capital chief Treasury strategist David Ader. “This is pretty much them putting their foot down and making a statement. The Fed’s independent indeed.”

Strategists said the prospect of mortgage purchases has already spurred buying of mortgage securities.

“The ultimate affect hopefully is mortgage rates come down, more people can take advantage of it, mortgage rates can stay low," Ader said. "Maybe if we weaken the dollar a little bit, it will help the beleaguered production side.”

“Keeping rates low has not helped unemployment," Ader said. "Keeping rates low has not brought on inflation. Keeping rates low has not hurt the dollar. Keeping rates low has helped the Treasury market.”